The Disadvantages & Advantages of Activity-Based Costing

Activity-based costs can help identify problems in production.

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Activity-based costing is a way to allocate costs based on the amount of resources a product or service consumes. The use of ABC is especially important to businesses that provide customized products or services. A customized production environment requires ABC s allocation of actual indirect costs to a product to identify its true cost. Implementing ABC can be a challenging task for any business and the process carries several advantages and disadvantages.

Expensive Implementation

Setting up an ABC system can be expensive and time-consuming. As business activities are analyzed, they must be broken down into each activity s individual components. The entire process can use up valuable resources as data are collected, measured and entered into the new system. Businesses may also need the assistance of a consultant who specializes in the setup of an ABC system and can provide training on its use. Using software can add an additional expense to the implementation but it can be used to automate many of the manual aspects involved in using ABC.

Misinterpretation of Data

Reports produced by an ABC system contain information, such as product margins, that vary from the information reported for a traditional cost method. It s also possible that some activity-based costs may be irrelevant in certain decision-making scenarios; for example, ABC does not conform to accounting standards and should not be used for external reporting. Since traditional cost figures tend to be the norm, interpreting ABC data along with regular accounting information can be confusing and lead to bad decision-making. The use of software can streamline the process of maintaining an ABC system and simplify its integration with regular cost accounting information.

Improves Business Processes

An ABC system allocates indirect costs based on a product s cost driver, or the factor that creates the cost. As costs are allocated per product, a picture starts to emerge of which business processes are performing well and which ones need to be improved. ABC can be used to identify non-valued added activities and can help to better allocate resources to efficient and profitable activities. The use of ABC can also add value to the continuous improvement of business processes.

Identifies Wasteful Products

The ABC method accounts for costs similar to the way production work is performed, allowing your business to better understand where overhead costs are going. The data can identify wasteful products and unnecessary costs, so that resources can be used productively. The method also helps to fix the price of products or services that are excessive or incorrect. Overall product and service quality can improve as ABC s data details production and cost issues that need to be resolved.